The Economy Isn't the Same as the Market

Last Updated Oct 15, 2010 10:15 AM EDT

For the past few years, investors have been bombarded with bad news on the economy. And while the National Bureau of Economic Research said the recession ended in June 2009, there's still a torrent of bad economic news:
As the director of research for Buckingham Asset Management, I hear daily from worried investors: "With all the bad news, stocks just have to go lower. We should be selling." I respond by pointing out that there's a major difference between economy and the market. First, certainly the large institutional investors that dominate trading (and therefore set prices) are aware of these facts. Thus, this scary information is already incorporated into prices. In other words, it's not that the stock market has to go lower because of the bad news. It's that the market is where it is because of the bad news. It's important to understand that if things weren't this bad, prices would be higher.

The big difference between the market and the economy is that the market is forward looking, and it's unexpected events that primarily drive future stock prices. Thus, it doesn't even matter whether future news is good or bad. What matters is whether it's better or worse than already expected. So with all the bad news, unless things turn out to be worse than expected, stocks should provide good returns. That's exactly what has happened since March 2009.

Clearly, the economy hasn't done well since March 2009. Yet, the S&P 500 Index has risen from its March 9 low of 677 to 1,179, a gain of 74 percent. The reason for the strong performance is that the market expected the economy to do even worse. The fact that the news wasn't good, but better than expected, fueled the rally. However, you would have benefited from that rally only if you had the discipline to stay the course.

Risk and expected return are positively correlated. The greater the perceived risk, the higher the expected return must be. Increased perception of risk is what causes bear markets. But the lower prices that result also mean that expected returns are higher. While expected returns aren't as great as they were in March 2009, the market is trading at a price-to-earnings ratio of about 14 (a bit below its historic average), due to 2010 earnings for the S&P 500 companies now forecasted at about $80 a share and the index near 1,200. Thus, stocks aren't highly valued.

We can't accurately predict what future returns can be, and neither can anyone else. Thus, the winning strategy is to have a well-designed plan and make sure that your portfolio's risk doesn't exceed your risk tolerance. That will help provide the discipline needed to adhere to the plan when risks inevitably show up.
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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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